Simon Tischer

Scalable Capital: Algorithm-driven investment

Scalable Capital is a poster child of the Munich fintech scene. The startup has been on the market for a mere two years and manages more than 600 million euros of its clients’ assets — with a strong upward trend. We spoke with Erik Podzuweit, co-founder and CEO of Scalable Capital, about financial investments, his company and the point of cryptocurrencies.

It might sound a bit premature to call and four-year-old company a success. But there are many reasons to do so in this case: Based on a round of financing completed in summer 2017, the company has been estimated to be worth 150 million euros in media reports. The company itself has not commented on the estimates. At that point in time, the startup was managing less than half of their current clients’ assets. If business valuation is used as the benchmark for the success of a startup — which is quite common — we are undoubtedly dealing with a success story.

So far, Scalable Capital offers its services in Germany, the UK, Austria and Switzerland. An additional European country may be added this year. The company cooperates with Siemens Private Finance and the direct bank ING-DiBa. In December 2017, Scalable Capital was already managing 600 million euros, with an additional two to four million euros being added each day. Even by a cautious estimate, the billion mark will be reached in the first half of 2018. But why are private individuals trusting a startup with their money? After all, the minimum investment is 10,000 euros.

Scalable Capital invests its clients’ wealth in exchange traded funds, or ETFs for short. These funds replicate the activity of stock indexes like the DAX as accurately as possible: If prices go up in the markets, the corresponding indexes go up as well. If the prices drop, ETFs also go down in value. The company charges an annual fee of 0.75% of fixed assets. Clients select the risk category based on a suitability test, but investment decisions are taken care of by an algorithm — or what is known as a robo-advisor.

This kind of asset management is based on passive index funds that are adapted over time by an algorithm, but there is also an alternative, namely active funds: In this case, experienced fund managers attempt to generate better returns than the market by cleverly buying and selling securities, for which they charge a fee. Advocates of ETFs and robo-advisors believe, however, that human investment managers on average do not perform better than the market and that fees only take away from the return. Erik Podzuweit is naturally on the side of passive index funds and a technology-based approach. We had some questions for the co-founder and CEO:

Let’s get right to the point: Why should I give Scalable Capital my money and not invest it in ETFs myself?

First, I would congratulate anyone who knows what ETFs are: namely the most cost-efficient way to diversely invest in capital markets. Anyone who has realized that is already among the best informed 10-15 percent of private investors. If you have time for it, it is a good idea to make smart investments in ETFs. It is the most cost-efficient way to take control of your investments.

One of the two main arguments that make the case for Scalable Capital and other robo-advisors is that we take care of the product selection for investors. Investing in ETFs is actually not as simple as you might think: Approximately 2,000 ETFs can be purchased in Europe. A few dozen are added each week, and the market is constantly changing. ETFs can be differentiated based on different criteria such as costs, conditions and tax aspects.

Emotions affect private investments

The second component is the investment strategy. A classic recommendation for private investors is a buy-and-hold strategy, which means buying ETFs and keeping them for 20 years. You might be subject to fluctuations, for example the DAX keeps plummeting during that time — by 75 percent in 2000 due to the dotcom bubble, and then again by 50 percent in 2008, but it always recovers in the end. The problem is that a lot of private investors and even professionals are not able to stay the course. Right as the index drops, you might be able to deal with initial losses. But at some point, people become emotional and start to panic. So they bail out and take the loss. What happens after that, however, is much worse: They stay on the sidelines and don’t get back in the game. That is why we find it beneficial for most individuals to take the emotion out of financial investments and to hand it over to an asset manager — but certainly not to an investment advisor who aims to sell products. With us, a software program makes the investments. That means not even our own emotions are involved. In addition, we also put our investor’s portfolio together to exactly correspond to their risk preferences. We frequently see private investors put their own ETF portfolios together, but then end up with a much higher risk than anticipated because they do not have the tools to properly gauge the risks. They also diversify based on “gut instinct,” which often leads to sub-optimal portfolios.

Erik Podzuweit (Photo: Scalable Capital)

A third argument for robo-advisors is from a completely different angle: 20 percent of our clients are bankers. It might sound like a paradox, but many of them do not feel like dealing with financial matters during their time off, or they have to hand off their private investments due to compliance requirements. With us, they can put in or take out money and chose the risk category, but have no say about the selected ETFs. That is what makes us a good match for individuals in the finance industry such as consultants, auditors or bankers.

“There is no point in reading the paper and to then guess how the markets will develop”

So why should finance professionals not simply go to an investment advisor?

The term “advisor” in itself is already misleading, because an investment advisor’s set objective is to sell funds. That might sound like a stereotypical argument, but I’ve experienced it myself.

The fees for investment advisors are also relatively high: Actively managed funds cost around 1.5 to 2 percent on a running basis each year. On top of that, you have portfolio management, expenses, trading costs. It is normal to have annual costs amounting to roughly 2 to 3 percent. With 0.75 percent plus ETF fees that currently run at approx. 0.25 percent, we are much lower than that. You might say that most robos are 50 to 70 percent more cost effective than classic investment advisory services.

Another argument is the investment methodology: It used to be common for classically managed funds to be presented with a matching story like: “I’m an Asia expert and travel to Hong Kong three times a year.” That sounds reasonable enough. The strange thing about the world of finance, however, is that the average portfolio manager who does their homework and makes an investment decision is no better than an investment — which is usually much less expensive — made in the corresponding market index. There is no point in reading the paper and to then guess how the markets will develop. The markets are too efficient at determining the price structures of new information.

What we do instead is count on an algorithm that is much more efficient than any human bank advisor at evaluating the data that is genuinely important, namely the data about market risks. Of course, we are not the only ones. Major institutional investors have been working this way for the last 15-20 years. Our algorithm is also not some kind of philosopher’s stone or a crystal ball that predicts skyrocketing prices — that doesn’t exist. What we do basically is use cutting-edge technology to transform what is known from the latest financial research about how capital markets and time series behave, the fact that risk, as opposed to return, can be effectively modeled and predicted. What makes us innovative is offering this kind of robo to private investors. It only takes 20 minutes on your smartphone to become one of our clients, and we take care of the rest.

“In the finance industry, it’s a trend to have a professor or at least some guy with gray hair on board.”

Your team has three former Goldman Sachs bankers and a professor of statistics. How was Scalable Capital founded?

Florian, Adam and I worked in a team together at Goldman. They were both traders in London, and I looked after banks and investment managers on the client side in Frankfurt. For a long time, I would say I was a “wantrapreneur”: You meet up and get to thinking over a beer together, come up with great ideas. But if you never quit your day job, nothing happens. I went to Westwing in 2013, and that was my first step into internet business. In summer 2014, we made the decision to start our own company and then quit our jobs. I already knew Stefan Mittnik from Kiel before he switched to the LMU in Munich. He was one of my professors back then.

When I asked him if he wanted to work with us, he immediately agreed during our talk. He was the main reason we founded the company in Munich. He established contact with former and current PhD students as employees for us. Connections to the LMU and the proximity to the TUM are excellent. That really helped us. In retrospect, it was all a major coincidence: If I had not known him already, I would have met him at some point.

We established the company in 2015, applied for and received approval from the German Financial Supervisory Authority (BaFin), raised venture capital, hired employees, the whole deal. Then we started looking for clients in early 2016.

Be honest: Is Professor Mittnik active in operative business, or is he just a figurehead?

In the finance industry, it’s a trend to have a professor or at least some guy with gray hair on board to look serious. But Stefan Mittnik really is completely on board. He is a founder, has a hefty founder’s share since he invested in the company with private risk capital, and he developed the algorithm. Our office is in the Prinzregentenstraße, which is maybe a five minute bike ride from the university. He is our academic advisor, closely involved and also takes part in many client events. We recruited almost all of our colleagues in the financial engineering team with his network.

It’s all good in Munich

Even if you ended up in Munich more by chance — how satisfied are you currently with the city?

Even though I am a Berlin native and also live there, we are very pleased to be in Munich. For example, there are more qualified computer scientists here than in Berlin. As a fintech company, that aspect of tech is extremely important. People are also not so jumpy — I think there is less fluctuation.

Moreover, we are also fully supported by regulators, administrators and politicians. As a fully regulated company, we are under supervision by the German Bundesbank and BaFin. The Bundesbank is decentralized and has its own office in each German state. The branch in Munich is extremely pragmatic and cooperative. If you are not able to reach somebody, they simply call you back on your cell phone. They want fintechs to settle in Bavaria. Administration is also highly efficient here: If we need a Blue Card for foreign employees, which is a work permit for highly-qualified jobs, then it gets taken care of quickly and without any trouble.

Support from the political realm is also exceptional: We were invited to the Bavarian Finance Summit right at the beginning by the Minister of Economics, Ilse Aigner. That was where we met Siemens, and we now have a cooperative agreement with their subsidiary Siemens Private Finance. ING-DiBa sat at the same table with us, and we also have a partnership now. We also communicate quite actively with the Ministry of Economic Affairs.

And there’s one more thing: We work in wealth management. Although we are also interested in reaching a somewhat wider audience, wealthy customers are quite interesting for us. That makes Munich and the surrounding area a super location.

And where do you see room for improvement?

The infrastructure needs to grow more. We were in Werk1 at the very beginning, and that was cool. Then we quickly grew out of the space. We wanted to rent an office that was centrally located. The landlords wanted to see our annual reports from the last two years. But we had only existed for two months. When asked how we planned to pay the rent, we said we receive venture capital. That got us some frowns here and there in response. In short: In some respects in Munich, there is a lack of experience in dealing with startups. Perhaps Munich could consider creating an official hub just for startups. In Prenzlauer Berg in Berlin, you have one startup after the next, but it is much more scattered in Munich. But otherwise, it’s all good!

Branch-based banks and the Innovator’s Dilemma

What lies behind your cooperation with ING-DiBa? Why do they need you?

ING-DiBa might be Germany’s third largest bank after Deutsche Bank and Commerzbank according to the number of clients, but it does not have branches and does not offer investment consultation or investment management. They wanted to set up online investment management and thought it would be faster and better to look for the best partner in Europe. We came out on top in a Europe-wide bidding process.

So it was their advantage that they would not have to cannibalize themselves to establish online asset management?

Exactly. The other major banks are certainly capable of building their own robos. The problem is the internal cannibalization process. They have thousands of branches and advisors. They often have their own actively managed funds, which usually makes them high-margin. Then you come in with a service that is less expensive and supposedly better than branch consulting. They would then have to switch their investment funds, with which they earn 2 percent, to ETFs. That would leave them with just 0.5 percent or even less. That is when the management board for branch operations starts to tell you off. It’s a major problem; the Innovator’s Dilemma: Banks see what’s happening, but there’s no other way for them to react. ING-DiBa didn’t have that kind of conflict.

ICOs: “90 to 95 percent are a complete rip-off”

What is your vision for Scalable Capital — where do you see it heading?

We want to become the ETF concierge in Europe. Let’s say you hear or read about ETFs, but don’t want to learn more about it yourself or know you are not experienced enough in the subject, so you immediately think of Scalable Capital. The prospects are looking good for achieving that.

And now the unavoidable question for a finance expert: What’s your opinion on cryptocurrencies and ICOs?

That has almost become a daily topic for me: in the office, with investors, while taking a taxi. In my circle of friends, there are some who do not know the difference between shares and bonds or what an ETF is, but they put their money in crypto. But I do think fundamental blockchain technology — a reliable system without central authority — is visionary. The idea is really powerful and will be successful. The use cases, however, are just being tested now. For example, if you live in Venezuela, you would probably prefer to invest your money in crypto than to exchange it on the black market. That being said, I don’t believe in a utopia where cryptocurrencies will eventually replace the dollar. And for investors in Europe, they are definitely not an alternative to a global, diversified capital market portfolio, such as one that might be used for retirement planning.

I’m extremely skeptical about the ICO boom. There are certainly projects that are valid, but 90 to 95 percent are a complete rip-off. They are not shares of a company like venture capital. They are the future right to use a business or software for which not a single line of code has been written. Some of the time you are dealing with teams that would never receive venture capital, so they deliberately act like they are giving shares of their companies in their White Papers. The ICO market is going to blow up in our faces. Then we’ll see which projects actually have something to offer. To summarize: There will be use cases for crypto in the long term, even if it is difficult to gauge the “right” ratings; I am a genuine blockchain fan, but stay away from ICOs!

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